What Caused The Flash Crash?

Experienced investors, particularly those who have worked for a while on Wall Street, like to believe that they have seen it all and try to project an air of slightly dismissive boredom with the day-to-day gyrations in the markets. On May 6, though, hundreds of would-be masters of the universe were in utter panic as the markets melted down in spectacular fashion.

In what is now being called the "flash crash", the Dow lost over 700 points in a matter of minutes, at one point being down nearly 1,000 points for the day, before storming back. In the wake of that craziness, exchanges and investors had to sift through broken trades and regulators are still trying to figure out what happened.

Clear Out the Dross FirstBefore talking about what may have happened, let us begin with some of the exciting theories that have been roundly discarded by the experts.

The Fat FingerThis describes a trade where a human input error leads to a significantly erroneous trade, like adding an extra "zero" to an order. In this case, there was a rumor that a trader mistakenly input a sell order for either S&P 500 futures or Procter & Gamble (NYSE:PG) stock as "billion" instead of "million". It is an amusing idea, but there are fail-safes at trading houses and exchanges that would flag such a mistake.

Rogue Traders and TerroristsThere have been stories claiming that certain investors sold a large amount of futures or bought a large amount of puts just before the crash began. Likewise, others have whispered that it was a cyber attack by the likes of Al-Qaeda or the Chinese. In all cases, regulators and investigators have found no evidence to support these ideas and if it was due to the actions of a single U.S. money manager, we would know by now. (It may have not been the case this time, but terrorist activity tends to have a negative impact on the markets. Find out how to take cover. Read Terrorism's Effects On Wall Street.)

What May Have Really HappenedIn point of fact, I consider it a near-certainty that there was no single cause of this flash crash. More likely, it was a series or collection of events that happened to just all go wrong simultaneously, and this appears to be the current position of U.S. financial regulators as well.

One detail is important to understand. Prior to the drop in the stock market, there was a drop in the S&P e-mini futures. These are futures contracts traded on the Chicago Mercantile Exchange and are hugely popular with traders, and the daily dollar volume is often much higher than that of the actual stocks in the S&P 500. These contracts matter, though, because of arbitrage - the price of the S&P futures and underlying stocks are linked and will move together. (Learn more about this advanced trading technique in Trading The Odds With Arbitrage.)

Sudden Liquidity DrainGenerally speaking, there are about a half-dozen firms that provide about half of the liquidity in the e-mini futures. That is a huge amount of volume in the hands of a small cadre of traders. It appears, though, that as selling began on that fateful day some of these traders left the market. As we have seen in every financial market (whether stocks, bonds, options, or futures), a sudden drop in liquidity can be very bad for prices and morale and prices can fall precipitously.

Stub QuotesHave you ever looked up a quote for a stock outside of market orders and seen a bizarre bid-ask spread like "Bid - 0.01 Ask - $100,000"? That is a stub quote. Market makers are required to maintain active bid and ask prices for their stocks, and those prices are supposed to be legitimate.

In practice, though, sometimes market makers do not want to trade and that is when they will offer those ridiculous spreads. There is never any intent to actually do business at those prices, but they are real offers and when computerized systems cannot find a better place to execute a trade, those stubs will get hit. That, in a nutshell, is how we saw some stocks trade for one cent on the day of the flash crash.

Mismatched Trading RulesUnfortunately, the various stock exchanges open to investors and traders do not have a uniform set of rules. The simplest example is the NYSE which still uses a mix of electronic and human trading. In periods of exceptional chaos or volatility, these mismatches in rules can cause big disruptions in order flow and liquidity, sometimes moving trades away from markets with willing traders and credible quotes and into the periphery where issues like stub quotes become relevant.

Intermarket Sweep OrdersThis is a relatively unusual type of stock order that is almost never used by regular investors. Typically, investor orders are routed to whatever market offers the best price - many NYSE-listed stocks are actually traded through Nasdaq or electronic exchanges. Some investors, especially those engaged in algorithmic trading, will use a sweep order to direct trades to a specific market regardless of price. That can lead to trades being executed at very strange prices if there is a failure in liquidity in the markets. In the flash crash there were many strange quotes for NYSE-listed stocks trading on Nasdaq.

Stop-Loss OrdersStop-loss orders are often promoted as a way of reducing risk, but they can actually amplify a crisis under certain conditions. Stop loss orders become active when a stock declines to a certain level and create automatic sell orders. If a stock or index is dropping rapidly, an influx of sell orders can function like throwing gasoline on a fire. It is entirely possible, then, that the triggering of thousands of stop loss orders led to a flood of sell orders and an extreme amount of downward pressure on prices for a short period of time. (Learn more in The Stop-Loss Order - Make Sure You Use It.)

ArbitrageAlong similar lines, the linkage between futures and stocks cannot be ignored. Arbitrage is a well-known and reputable part of a healthy and functioning market, but it can lead to strange results in volatile times. As the S&P futures dropped, it triggered automated orders to sell the underlying stocks, which triggered a vicious cycle as the selling in futures led to selling in stocks which led to more selling in futures.

Is There Anything an Individual Can Do?Unfortunately, systematic breakdowns are an inevitable weakness of any elaborate system. In other words, despite the best intentions of the SEC, exchanges and brokerages, something like this will happen again eventually. The best thing an individual investor can do is to use stop-limit orders instead of stop loss orders. A stop loss order means that once a trigger price is reached, an order is issued to sell that stock as soon as possible, at whatever price. A stop-limit order, however, is likewise triggered by a decline in the stock price but the order specifies a price below which the trade is canceled. That may not sound like a great solution, but it at least offers the hope that a crazy hour in New York will not leave you with precipitous losses.